Efficient Incentive Contracts - Harvard University

EFFICIENT INCENTIVE CONTRACTS

MARTIN L. WEITZMAN

A so-called "incentive contract" is a linear payment schedule, where the buyer pays a fixed fee plus some proportion of audited project cost. That remaining proportion of project cost borne by the seller is called the "sharing ratio." A higher sharing ratio creates more incentive to reduce costs. But it also makes the agent bear more cost uncertainty, requiring as compensation a greater fixed fee. The tradeoff between incentives and risk in determining the sharing ratio of an efficient contract is the central theme of the present paper. A formula is derived that shows how the optimal sharing ratio depends on such features as uncertainty, risk aversion, and the contractor's ability to control costs. Some numerical examples are calculated from the area of defense contracting.

SUMMARY

This paper analyzes the widely used "incentive contract"-a linear payment schedule where the buyer pays a fixed fee plus some proportion of project cost. The remaining proportion of project cost borne by the seller is usually called the "sharing ratio." A higher sharing ratio creates more incentive to reduce costs. But it also makes the contractor bear more risk, requiring a greater fixed fee as compensation. The basic contribution of the present paper is a simple formula showing explicitly how the optimal sharing ratio depends on such features as uncertainty, risk aversion, and the contractor's ability to control costs. The formula is applied to some numericalexamples drawn from the area of defense contracting.

Designing an efficient contract is an example of the so-called "principal-agent problem." While the basic theoretical issues are fairly well understood,1 results are at a rather high level of abstraction, somewhat removed from the realm of practical application. At the other extreme is a rich body of descriptive material about an already institutionalized linear contract2 (the "incentive contract"). In this paper I want to strike a middle position. Because a linear payment schedule has a simple structure, explicit formulae for an efficient contract can be derived that show clearly the tradeoff between risksharing and incentives.3 This has immediate applications, since the "incentive contract" is used in practice.

1. See, e.g., Holmstrom [1979], Ross [1973], Shavell [1979]. 2. See, e.g., Fox 11974], Moore [1967], Peck and Scherer [1962], Scherer [1964b], and Williamson [1967]. 3. The interested reader may want to contrast my approach with the earlier work of Berhold [1971], Cummins [1977], and Scherer [1964a].

? 1980 by the President and Fellows of Harvard College. Published by John Wiley & Sons, Inc.

The Quarterly Journal of Economics, June 1980

0033-5533/80/0094-0719$01.20

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CONTRACT TYPES

Two polar contract types4 have been in widespread use for a long

time. At one extreme is the "cost plus" contract (Cost Plus Fixed Fee

= CPFF). This contract type pays actual costs plus a fixed dollar fee that is usually determined as some percentage of a cost estimate. Once set, the fee is fixed. The buyer additionally compensates (within limits) all legally allowable costs incurred by the contractor in fulfilling the project. The CPFF contract has the significant drawback of providing no incentive for cost reduction, which results in a well-known tendency to cost overrun.

The opposite extreme is the "fixed price" contract (Firm Fixed Price = FFP). Here the contractor agrees to fulfill the project for a fixed dollar price, which, once negotiated, will not be readjusted to include actual cost experience. With every dollar of cost saved ending up a dollar of extra profits, a strong incentive is created to reduce project cost. The disadvantage of the FFP arrangement is that the firm, bearing all the risk, must be compensated by a fee representing on average a high nominal profit rate.

The "incentive contract" falls between the polar extremes of CPFF and FFP. Sometimes called Cost Plus Incentive Fee = CPIF, sometimes Fixed Price Incentive = FPI (depending on which of CPFF or FFP was its conceptual antecedent), an incentive contract essentially pays a fixed fee plus some fraction of project costs.5 No matter how varied the way it is represented or the names of its different parameters, the principal's payment under an incentive contract can always be written in the reduced form:

(1)

K + (1-X)X,

where X is the accounting cost of the project, K is the fixed fee, and A is the agent's share of project costs (the principal's share is I -

O). Note that A = 0 is cost plus and A = 1 is fixed price. Thus, CPFF

and FFP are special polar cases of expression (1). An incentive contract offers the possibility of striking a balance

between the positive incentive effect of a high sharing ratio and the negative risk effect. The purpose of this paper is to formulate the

4. For more detailed information see Cummins [1977], Fox [1974], Moore [1967],

and Scherer [1964a, 1964b]. 5. In practice there may exist ceilings or floors, which are ignored because they

are rarely penetrated. See Scherer [1964al, p. 258.

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problem of selecting an optimal sharing ratio and show clearly how the solution depends on various factors.

A MODEL OF THE CONTRACTOR FIRM

Suppose that a contract is let for some well-defined project. Consider a firm that has agreed to undertake the project. Let X be the accounting cost of the project.6It is supposed that the firm engages in some variety of economic activities. Total net profits attributed

to the firm's other activities, excluding this project, are denoted 4.

Suppose that, through bilateral negotiation between principal and agent, or by competitive bidding, or even by some other process, a mutually acceptable combination of fixed fee K and sharing ratio X is obtained. The buyer agrees to compensate the seller by the terms

of the incentive contract (1). The contractor's total net profit is

(2)

w= K + (1-X)X + -X,

which can be rewritten as

(3)

wr= K-AXX+ .

Thus, the sharing ratio X is like a "price" per dollar of cost overrun to the contractor.

Generally speaking, there is a tradeoff between X and 4'.Project

costs can be made lower if net profits in the rest of the firm are also lowered.

There is a variety of discretionary actions the firm can take to

influence jointly X and 4'.Unmeasured, hidden, or imperfectly im-

puted resources (such as managerial attention or some kinds of overhead) can be shifted between the contracted project and other activities, or an externality between X and 4Amay be involved. Perhaps by doing more R&D or learning under the contract, the firm can trade higher costs on this project for greater long-run profits generated by strategic advances that spill over into future economic activities. Other stories can also be told.

An essential ingredient of the environment I am trying to model is uncertainty. The terms of the contract are established in an atmosphere where project costs are not precisely known.

6. In practice, it is difficult to measure precisely (or even to define) project-related costs, and some degree of arbitrariness is inevitable. Certain costs can be attributed directly to the project. But others, like overhead costs, cannot easily be assigned to one activity or another, and some project costs, like managerial attention, are hard to

measure, observe, or monitor.

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Once set, K and X cannot be renegotiated. But after the uncertainty resolves itself, the firm will adjust discretionary action under its control to maximize total profits, given K and A.

Let 0 represent a state of the world bearing on this project. For example, materials might be more or less expensive, construction conditions may vary, research and development outcomes could differ, etc.

In state of the world 0, let

(4)

V= Fo(X)

be a function representing the maximum Attattainable for a given X.

Under state of the world 0, in profit-maximizing equilibrium the firm will choose X0(X) and {0a(X)to maximize

F0(X) - AX,

yielding the first-order condition,

(5)

F0= X

or

(6)

-XA(X) + 4(X) = 0.

When X < 1, condition (5) indicates inefficiency, because the marginal rate of transformation between project costs and revenue earned elsewhere is not one to one. Instead, a dollar saved on the project is only equivalent to the fraction X of an extra dollar earned on other activities of the firm, due to partial reimbursement of project costs at 1 - X to the dollar. The lower X is, the less the incentive is to cut costs on the contracting activity at the expense of profits in the rest of the firm. On the other hand, when X is higher, the agent must bear a greater share of cost risk, and K must be made sufficiently larger to induce the firm to accept the contract.

EFFICIENT INCENTIVE CONTRACTS

Parameters K and Aare fixed when the state of the world is uncertain. That level of expected utility that the firm obtains is a function of its bargaining strength and the kind of negotiating process that takes place. Whether determined by bilateral confrontation or competitive bidding, it is in the common interest of buyer and seller to negotiate parameter values that are Pareto efficient with respect to the given form of the contract. Even if forces making for Pareto op-

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timality are weak in practice, characterizing an efficient incentive contract is still an important normative issue. This is especially true because, as long as the optimal sharing ratio is relatively invariant to expected utility levels, the buyer can set it at the efficient value and limit negotiations to determining the fixed fee.

Assuming that the theoretical difficulties associated with representing collective choices are insignificant, let the agent's utility function be U(-) and the principal's utility function be V(-). For most applications V is more linear than U, because the government (or any large buyer) is likely to be less risk-averse than the contractor. In fact, the government is frequently assumed to be risk-neutral as a first approximation.

Let U be a given level of the contractor's expected utility (it may be varied parametrically). The expected value operator over 0 is denoted E.

An efficient incentive contract (X*,K*) solves the problem,

(7) subject to

max EV(-K - (1 -)X0(X)),

XK

(8)

EU(K - XXG) + 4(X)) = U

(9)

F 0=X.

Formally speaking, (7)-(9) has a generic relationship to problems in the theory of optimal income taxation and competitive insurance contracts.7 However, besides being worthy of analysis on its own merits as an important economic issue, the efficient incentive contract has a special structure that allows a distinctive characterization.

THE OPTIMAL SHARING RATIO

Our main interest is in characterizing the sharing ratio X*,which is the solution of (7)-(9). Once X*is determined, the optimal fixed fee K* can be calculated as a residual from equation (8).

With X0(X) and A(X)defined as solutions of (9), condition (8) implicitly determines K as a function of X.Writing K(X) as that value of K which satisfies (8) for a given A, I can show that

(10)

EU(K(X) - XX0(X)+- 4' (X)) = U.

7. See, for example, Mirrlees [1971], [1976], Sheshinski [1971], and Spence and Zeckhauser [1971].

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